5 9.1 Internal Balance and External BalancePolicy InstrumentsExpenditure-changing policies include fiscal policy and monetary policy, altering the level of aggregate demand for goods and services which are either produced domestically or imported.Expenditure-switching policies refer to exchange-rate policies, including appreciation or depreciation of a currency, which shifts the direction of demand between domestic output and imports.

6 9.1 Internal Balance and External BalanceWhen an economy is located in the disequilibrium zones of Quadrant I and III, expenditure-switching policies can restore the economy to overall balance.In Quadrant I: An appreciation of its currency decreases the international competitiveness of its goods and leads to a fall in export, which, on the one hand, decreases its BP surplus, and on the other hand, reduces its aggregate demand and thus output, lessening its inflation.In Quadrant III: A depreciation can restore the overall balance.

7 9.1 Internal Balance and External BalanceTinbergen RuleOne economic goal could be attained by at least one effective policy tool. Thus, to achieve n independent goals, we need no less than n effective policy tools.

8 9.1 Internal Balance and External BalanceMeade ConflictUnder fixed exchange rate system, a country cannot change its exchange rate and thus it loses expenditure switching policy tools. In this condition, the goals of internal balance and external balance may become conflicting since the government now can only resort to expenditure changing policies.

9 9.1 Internal Balance and External BalanceIn Quadrant I, the economy will meet the conflict between internal balance and external balance.A contractionary expenditure changing policy will reduce output and income, decreasing the inflation and restoring internal balance. But reduced national income then weakens imports, enlarging its BP surplus and worsening its external imbalance.If the government uses an expansionary expenditure-changing policy, the external balance can be achieved but the internal economy will be imbalanced with more severe inflation.In Quadrant III, the economy will also meet the conflict between internal balance and external balance.

12 9.2 Policy Mix to Achieve Internal Balance and External BalanceMundell Assignment RuleFiscal policy and monetary policy have different effects on internal economy and external economy. So even under fixed exchange rate system, it is likely to utilize fiscal policy and monetary policy to achieve both internal and external balance.Fiscal policy and monetary policy may affect national income and the current account to the same extent. But they have different influence on the interest rate and the capital and financial account.Contractionary fiscal policy can reduce the interest rate, causing capital outflows and worsening the capital and financial account.Contractionary monetary policy will increase the interest rate, causing capital inflows and improving the capital and financial account.

15 9.2 Policy Mix to Achieve Internal Balance and External BalanceConclusion:Fiscal policy should be assigned to solve internal imbalance while monetary policy should be assigned to solve external imbalance.If policies are wrongly assigned, the economy will diverge from the overall balance.

22 9.3 Effects of Macroeconomic Policies under Fixed Exchange RatesEffects of Fiscal Policy under Fixed Exchange RateFiscal policy has no effect on economy under fixed exchange rate when capital is perfectly immobile, only to find a higher interest rate.Fiscal policy has some effect on economy under fixed exchange rate when capital is imperfectly mobile. But the extent of effect relies on the sensibility of capital flow to changes of the interest rate. The more sensible the capital flow is, the larger the effect of fiscal policy is.Fiscal policy has perfect effect on economy under fixed exchange rate when capital is perfectly mobile.

28 9.3 Effects of Macroeconomic Policies under Fixed Exchange RatesEffects of Monetary Policy under Fixed Exchange RateMonetary policy has no effect on economy under fixed exchange rate regardless of the extent of capital mobility.

34 9.4 Effects of Macroeconomic Policies under Floating Exchange RatesOn BP curve, r0 and Y0 keeps the economy in external balance.A depreciation results in more export and less import, leading to a surplus of the balance of payments.To digest the surplus of the balance of payments, national income needs to grow in order to encourage more import.At any other interest rates, the same thing happens.